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Jeff Saut Presents: If?!


...the damage that has been done to the various indices is severe.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowances for their doubting too;
If you can wait and not be tired by waiting,
Or being lied about, don't deal in lies,
Or being hated don't give way to hating,
And yet don't look too good, nor talk too wise.

. . . Rudyard Kipling

Over the weekend I thought a lot about the events of this year. Those reflections were an attempt to prepare for my presentation at "Minyans in the Mountains III" where the investing public will be able to listen to, and hobnob with, some of the brightest minds on Wall Street. Currently, however, the event du jour is clearly what is occurring in Lebanon. As we stated on CNBC last week, we think the situation cannot be analyzed for multiple reasons. For example, will Israel extend its incursion into Syria? Will Iran become involved? Will oil be used as a weapon? And, the list of questions goes on and on. Moreover, we can't fathom what Hezbollah's goal was in inflaming Israel to the point of war that threatens Hezbollah's very existence? Typically such actions have an objective, but in this case Hezbollah's actions make no sense to us. I mean, what do they win . . . what is their goal? And evidently I am not the only one in wonderment, because the silence from most of the Arab-speaking world has been deafening! Yet with Israel mobilizing its reservists, we can't shake the feeling that there is another "shoe" yet to drop.

Adding to the event-driven backdrop is the "showdown" between the U.N. and Iran on its uranium enrichment program, escalation of the Iraq situation, North Korea, North Africa, the July 18th release of a battery of Chinese economic data, the one-year anniversary of China's new exchange rate regime (over the last 12 months China's Rimimbi has appreciated nearly 4% against the dollar), this week's inflation reports (PPI/CPI), the kickoff of peak earnings season for Wall Street, and this week's two-day testimony by Ben Bernanke. And if Mr. Bernanke does another "Maria" flip-flop, the markets could really be back in the "soup." One thing we think we know, however, is that the NYSE Specialists are "on their knees" and can't take much more of this kind of selling. The implication is that on a short-term basis the selling should temporarily stop sometime this week to give the stock-heavy Specialists some kind of relief rally in which to sell some of the burgeoning stock positions they have had to take on over the past few weeks. While we played the last relief rally (that began on June 14th) in the trading account, we are not so certain we are going to play this envisioned trading rally. The reason is that NONE of our proprietary indicators are nearly as oversold as they were back in mid-June. Nor can we shake the sense that there will be another "shoe to drop."

Additionally, the damage that has been done to the various indices is severe. Indeed, many of the indices we monitor have broken below their respective June reaction lows and now reside below both their 50- and 200-day moving averages (DMAs). Additionally, the S&P 500 (SPX) has broken to the downside out of a rising wedge formation in the charts, as can be seen in the chart following this commentary. Listen to what the book "Technical Analysis of Stock Trends" has to say about a rising wedge chart formation:

"As a final note, we might add that the Rising Wedge is a quite characteristic pattern for Bear Market rallies. It is so typical in fact that frequent appearance of Wedges at a time when, after an extensive decline, there is some question as to whether a new Bull trend is in the making, may be taken as evidence that the Primary trend is still down. . . . A Rising Wedge on an arithmetically scaled weekly chart is almost invariably a Bear Market phenomenon."

Bear market or not, we think when the Israeli/Lebanon conflict is resolved the markets' focus will revert to the problems evident before the "Israeli war." The most troubling of those problems, in our opinion, is what is occurring in the real estate markets and the concurrent negative "wealth effect." Indeed, according to Raymond James' real estate team, $2.7 trillion worth of adjustable rate mortgages will reset at higher interest rates over the next few years, depressing disposable incomes. They further noted in their recent real estate report:

"Examining the fundamental environment for housing, the current situation appears somewhat more tenuous, in our view, than some observers may realize, particularly when compared to the cycle of the late 1980s. The primary driver of housing is affordability, in our view, and from that standpoint we are facing lower levels today than at the peak of the late 1980s cycle, in spite of the fact that mortgage rates remain some 300+ basis points lower today. Additionally, during the late 1980s, affordability trends were more favorable, meaning that affordability was improving following an extended period of unaffordable conditions during the late 1970s and early 1980s, whereas today conditions are deteriorating following an unprecedented period of very high levels of affordability."

They go on to state:

"From an inventory perspective, today also appears more challenging than during the late 1980s based on absolute levels of inventory (565,000 today vs. 358,000) as well as months' supply (5.8 months today vs. 5.0 months). Some pundits have prophesized that inventory levels should moderate, based on many investor cancellations having already been dealt with; thus, cancellation rates should slow in the back half. While we do not disagree with the thesis that investor cancellations may be moderating, we believe that, based on discussions with our contacts, most cancellations today are legitimate buyers who are walking away from earnest money deposits out of fear of declines in home prices. Furthermore, we expect inventory levels to build even further in the back half."

"Another aspect of inventory that we consider is the "hidden inventory" that we have written about extensively. This is inventory that is not currently captured in the traditional singlefamily inventory data because these are homes that are for rent, and show up in the rental stock data. Over the past several years, single-family vacancy rates have spiked, we believe as a result of a surge in investment by individuals in single-family real estate. In summary, given the high inventory levels in the various supply channels, there are more vacant houses in the U.S. today than at any time in history. We estimate that there are currently six million vacant housing units comprised of vacant for sale units, vacant rental units (including condos, duplexes, and apartments), and unsold homes in the new construction pipeline. We believe selling these inventory levels down to more normalized levels will take two to four years, similar in timeframe to the 1987-1991 housing correction.

The full context of this provocative report can be obtained from Raymond James and in our opinion is a "must read" because of real estate's knock-on wealth effect for the economy!

The call for this week: Last week, for the first time, the equity markets seemed to worry about a recession. We think what is happening in the real estate markets was the driver of those worries. Clearly, the rise in the price of gasoline, the wars, North Korea, etc. added to the market's consternations, yet "If you can keep your head when all about you are losing theirs" . . . you can make a lot of money in the various markets. Manifestly, for the "well prepared" investor that heeded our advice of rebalancing their portfolios since January 2006 (read: sell partial investment positions and hold the freed-up money from those partial sales in cash), the decline from mid-May highs is "thrilling" since it affords those with cash increasingly abundant investment opportunities.

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